The world of trading has changed considerably in the last 10 years. Not only are new products being traded, many markets trade globally in electronic marketplaces. People from all over the world trade our markets and American investors trade many overseas markets.
But just because it’s becoming more common doesn’t necessarily mean this global marketplace is simple. Besides differences in local laws, customs and technologies, there is the inescapable truth that most country’s futures markets are priced in the local currency. This means that trading profit or loss is not only based on the underlying futures market but it is also a currency play vs. the U.S. dollar.
Unfortunately, most trading analysis software does not support automatic currency conversion. This means that you need to be able to think in multiple dimensions when trading markets prices in other currencies. First, will the trade be profitable? Second, will changes in the currency value turn a winning trade into a losing one?
Another problem is that not all brokerage firms are experienced in trading these overseas futures markets. Your broker needs to understand the currency relationships, margins and how rollover rules work. We will begin our discussion by explaining the currency conversions involved in trading these markets.
Focusing on the ample opportunities available in Asia, we will build this initial discussion around the Japanese government bond.
On Oct. 19, 1985, the Tokyo Stock Exchange opened trading on 10-year Japanese government bond (JGB) futures. At the time, this was the first financial futures contract traded in Japan. The implementation of this futures contract was in response to market participants’ growing need for a tool to manage interest rate risk. It was also an effort to further internationalize the Tokyo Stock Exchange.
Although Asian volume in JGB futures has since migrated to the Singapore Exchange (SGX-DT), activity in futures based on this market has grown considerably. It is now regarded as one of the largest futures markets in the world. There are two different JGB contracts. One is a full-size contract denominated in Y100,000,000 with a tick size of 0.01 or Y1,000,000. This tick size makes it too large for most retail traders. The other JGB contract is one-tenth the size of its big brother with each tick being worth Y100,000 or about $8.50, depending upon the exchange rate.
Forex trading involves two simultaneous transactions where one currency is bought and an equivalent amount of the second currency is sold. Making the opposite transactions for both currencies closes a currency pairs trade. The difference in value of one currency with respect to the other at the time when the trade is closed results in the profit or loss.
Because the trading concerns a pair of currencies, the symbols used in listing it are pairs as well. For example, USD/JPY represents the currency pair dollar and the Japanese yen. The first symbol of the pair is called the base currency. The second symbol is called the quote currency. A price quote for a pair tells us how much of the quote currency is needed to buy or sell one unit of the base currency.
A complete quote consists of two prices. The bid price is the amount of the quote currency we will receive if we sell one unit of the base currency. The ask price is the amount paid in the quote currency to buy one unit of the base currency.
Usually, only the last two decimals of the ask price are included in the quote. For example, a possible quote for the USD/JPY pair is Y114.36/38. This quote tells us that we will be paid Y114.36 for selling one dollar and we will have to pay Y114.38 to buy back one dollar.
The smallest change in price for a currency pair is called a pip, which is an acronym for price interest point. For the pair USD/JPY, a pip is equivalent to 0.01 (the point size). The example price just given (Y114.36/38) showed a spread of 0.02 or two pips.
The pip value is the value in dollars of a change in price of one pip. This value is determined by the quote currency. The pip value of USD/JPY can change with the market.
FUTURES & CROSSRATES
Let’s apply this currency crossrate knowledge to our futures examples, the JGB, which is priced in yen. To convert our trade, we will use the USD/JPY crossrate.
On Jan. 23, 2006, the USD/JPY was Y114.36, which meant it took Y114.36 yen to buy one dollar. The value of the JGB futures—as well as the slippage, commission and the margin rate required to trade it—can be converted into dollars by dividing this crossrate by the price of the contract. We can convert current position profits using the same method.
P/L in US Dollars = (P/L in JPYen) / (Cross-rate US dollars / JPYen)
Without this step, any system backtest would produce results in the native currency. A novice trader who didn’t know any better might see a large number (such as 10 million) in profits and assume it’s dollars; in reality, that figure would represent yen (about $70,000 to $80,000). To complicate matters further, crossrates change daily and need to be adjusted throughout time over the course of the backtest to return a reliable representation of profits.
We can better understand how crossrates affect trading system tests involving non-U.S. markets if we walk through an actual example. We will take a classic 20-day channel breakout system and apply it to the JGB. The code is shown below:
Sub CHANBREAKOUT (SLen)
Here’s a trade-by-trade look based on a one lot of the JGB from March 2005:
The trade starting on March 17, 2005 and ending on June 17, 2005 made Y1.77 in terms of the contract. Because the size of the contract is Y1,000,000, this trade made Y1,770,000. Using a conversion rate of Y109.1793 per dollar, the profit is $16,211.86. This figure is obtained by multiplying net profit in points times 1,000,000 yen and dividing that by the conversion rate of 109.1793.
It is possible to do these conversions using an Excel spreadsheet. However, if we want to trade a portfolio of worldwide futures markets, software that performs this calculation automatically is considerably handy.
Looking at the bigger picture of trading overseas markets, many are quite liquid. Both the Japanese and European markets, for example, are considerably active. In July 2007, trading volume at Eurex reached 162.4 million contracts, an increase of 52% from July 2006 when 107 million contracts traded.
Equity index derivatives saw the strongest growth. The segment traded 62.5 million contracts, an increase of 66% over July 2006. Of that number, 27.2 million contracts were traded on the Dow Jones Euro Stoxx 50 index and another 19.8 million contracts in the Dow Jones Euro Stoxx 50 index option. Dax options and futures recorded a combined volume of more than 13 million contracts.
Contract turnover in the fixed income segment in July was up 45% to 73 million contracts. The DGB saw a volume of 33 million contracts in July 2007, and the shorter-term bobl and schatz futures were up 24% and 47%.
Although the logistical steps to trading these markets may seem cumbersome and boring, they are necessary evils when you are seeking to exploit overseas contracts. In the next installment, we will expand this discussion to include intermarket analysis as it applies to world markets and develop a simple intermarket trading system. We will also look at the role of arbitrage and try to learn more about this concept from studying the actual trades in a famous trading scandal, the Barings Bank collapse of 1995 brought on by the over-exuberance (and hubris) of Nick Leeson.
Murray A. Ruggiero Jr. is a consultant in East Haven, Conn. His firm, Ruggiero Associates develops market-timing systems. He is vice president of research and development for TradersStudio and author of Cybernetic Trading Strategies (John Wiley & Sons). E-mail him at firstname.lastname@example.org.